Golds’ profound effect on the value of the U.S. dollar and other world currencies

It’s been a long held belief that gold, the U.S. dollar and other world currencies have an inverse relationship. When the value of one goes up, the other goes down. You can certainly search the Internet and find an abundance of statements and papers on the subject going back decades.

Gold has historically been known to be one of the most stable assets. Unlike other minerals, it’s consistent and can be easily formed into bars, ingots, coins and other fungible (a.k.a. tradable) assets. Therefore, people place a lot of confidence in gold and trust it to protect and grow their wealth.

One of the reasons driving this motivation is currency depreciation as evidenced by the following 10-year chart showing the gold price in relation to major currencies in the world…all of them are up dramatically.

To understand what’s happening, we have to go back a few decades and examine some decisions made by the U.S. government and the Federal Reserve System, the central bank for the United States, and how these decisions affect how investors approach things.

August 15, 1971 – Bretton Woods Agreement breaks down with Pres. Nixon severing the final link between gold and the U.S. dollar

From around 1948 to 1971, exchange rates for the U.S. dollar and world currencies were linked to gold as setup under the Bretton Woods Agreement after World War II. The price of gold was fixed at $35 per ounce during this time. The Agreement ended up failing when too many people around the world were trading their U.S. dollars for gold.

Since 1971, the value of every world currency has been allowed to float and therefore, have become persistently variable against each other (and gold). How many times do you hear about the dollar being up or down against the Euro, Yen or some other major currency in the world?

Economically, this move provided some opportunities but created some dangers as well. Despite otherwise sound trade or investment positions, investors could experience heavy losses only because of currency fluctuations they had no control over.

To mitigate these risks and actually profit from them, investors turned to gold itself

Charles de Gaulle, the famous French general and president, once said something that really exemplifies why many investors have a lot of faith in gold as a store of value. He said “There can be no other criterion, no other standard than gold. Yes, gold which never changes, which can be shaped into ingots, bars, coins, which has no nationality and which is externally and universally accepted as the unalterable fiduciary value par excellence.”

De Gaulle certainly recognized the importance of a nation tying its currency to a tangible commodity like gold and the inherent stability available in owning gold.

For instance, pegging a currency to gold provides price stability because of the finite nature of the resource. Since there is a limited supply of gold at any one time, there can only be a limited supply of dollars. Without these constraints, governments and central banks can exercise much more control over the money supply for better or worse.

When these institutions expand the money supply too much, inflation can ensue which erodes the purchasing power of the dollars already in circulation. While it takes some time for these actions to be felt by ordinary people, over time they result in a consistent depreciation of the dollar. What may seem as “rising prices” for everyday things is in fact the erosion of the purchasing power of the money.

To give you a historical example, an ounce of gold was $35 per ounce in mid-1971. By 1980, the price climbed to nearly $850. At the same time, the U.S. and much of the world was wrestling with crippling price inflation.

When the dollar stabilized and began appreciating again in the early 1980s, the gold price fell back slightly and traded in the $250-$550 range for the next 20 years.

But since 2002, the U.S. dollar and other currencies have experienced much depreciation and like the ‘70s, gold prices have increased. Starting in 2001-2002, gold was around $275 per ounce…today (October 8, 2010) it’s trading for nearly $1350.

With debt projections that boggle the ordinary person’s mind, you can expect this trend to continue into the future. To pay this debt, governments and central banks around the world may simply create new money, or debts, to pay for prior debts. In the end, this will only lead to one thing for the value of the currency.

As you can tell from the 1970s case, the gold price just didn’t go back down all the way to where it started. So even if the value of the U.S. dollar were to rise once again, the gold price would likely not drop back to $275.

However, the likelihood of this happening in near-term is essentially zero.

So to protect your wealth from currency depreciation and even grow it, consider buying gold and other precious metals today. Provident Metals’ secure online ordering system makes investing in gold and silver quick and painless, with your order arriving on your doorstep in just days.